Business Forecasting

ECON2209
Slides 01

Lecturer: Minxian Yang

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About BF

Staff
Lecturer: Dr Minxian Yang, ASB452, 93853353, Fri 10-1
Tutors: see Tutorial Contacts

Prerequisite, required textbook & software

Requires ECON1203, required by ECON3206
Elements of Forecasting, 4th Edition, by F. X. Diebold
Software: Eviews in Labs: Mon 9-11 (QG021) & Tue 10-12 (MAT211)

Assessment

BF-01

Tutorials in Weeks 3 will be held in labs.

Class participation = 3%
2 Class-tests = 20 % (10% each)
1 Project = 17% (due week 12)
Final exam = 60%
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Submit the Project to Your

tutor before or at the
beginning of your tutorial!
No one else will accept your
submission.
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About BF

Objective of BF
Foster skills for analysing time series data and
capabilities of applying models, principles, techniques
in a business environment

Coverage
Focus mainly on uni-variate time series models, which
is the foundation for complex models.
Will touch upon multi-variate time series models.

Your knowledge in BF is a big plus in job market

Banks, financial institutions, government agencies,
consultancy firms: forecasters are valuable!
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About BF

Course resources
Course website:
announcements, course outline, lecture slides, tutorial
questions/answers, assignment, data, Eviews code
Library open (close) reserve
Discuss course material in consultation (not by email)

Read Course Outline carefully

Submission of project: your tutor, in time
Assessment: work, travel, wedding, cannot be excuses
Class participation: 80% attendance expected, be active

Make up your mind before the census day

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Ch.1 Introduction

Introduction
Forecast
A statement about the future values of a variable,
based on current knowledge

Purpose of business forecasting

To assist decision making
e.g.
Forecast sales/revenue for investment decisions
Forecast GNP/inflation/population for policy decisions
Forecast the risks of assets for risk management
Analyse what forecasts inflation
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Ch.1 Introduction

Essence of forecasting
e.g. Try to predict the next number
a) {2, 4, ?}.
b) {2, 4, 8, ?}.
c) {2, 4, 8, 14, ?}.
How did we predict?
Inspect data; (gather information)
Find a pattern; (fit a model)
Predict according to the pattern. (extrapolate model)

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Ch.1 Introduction

Essence of forecasting
Predict by exploiting the pattern in data
data

Pattern & model

prediction

Better data
More info about pattern
Better model
Better prediction.
Economists are better
at predicting the past than the future.
- Joseph E. Stiglitz
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Ch.1 Introduction

Uncertainty
Consider USD/AUD exchange rate.

No hope to perfectly predict the rate at 5pm, 1/April.

Similarly, it is impossible to perfectly predict
the sales/revenue of David Jones, or
the Australian inflation/GDP-growth.

Because there are more than one possible outcome!

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Ch.1 Introduction

Uncertainty
Forecasting under uncertainty is challenging:
Many possible outcomes (randomness): Perfect prediction is
impossible. Forecast errors must be allowed.

Sources of uncertainty:
Outcomes are affected by human (re)actions,
Also by many small factors that are hard to pin down.

Distributional regularities exist.

Central tendency: Extreme values are rare.
Dependence on the past: Tomorrow depends on today.
Regularities can be exploited to construct forecasts.

Major task: find distributional regularities (patterns).

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Ch.1 Introduction

Uncertainty
BF is about finding patters in data and using patters to
extrapolate:
If these patters persist, then the variables will behave with
these patters in the future.

We do not have a magic crystal ball.

Forecasting is not fortune telling!
Forecasting carries errors.
We try to minimise errors by
exploiting available information.
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Ch.1 Introduction

Forecasting Model
A good model captures major patterns in data.
eg.
Sales = Regular Sales + Disturbance
forecast object,
with past observations
pattern,
which is summarised by a model
unpredictable,
with distributional regularities

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Ch.1 Introduction

Topics to be covered
Framework of business forecasting
Forecast environment, loss function, info set, horizon,
parsimony principle

Statistical techniques
Time series description, classical decomposition, trend and
seasonality, ARMA models, estimation/testing, VAR models

Application emphasised
Data description (statistical/graphical), model selection,
interpretation of results, forecast statement
Implementation of models, EViews

End of Ch.1
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Ch.3 Basics of Forecasting

Basic Concepts of Forecasting

Contents
Decision environment
Forecast objects
Forecast horizon
Information set
Loss function
Forecast statement
Parsimony principle
Conditioning on information set
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Ch.3 Basics of Forecasting

Basic Concepts of Forecasting

Decision environment (know the role of forecasting)
Forecasts are used to support decision making.
Important to know the decision making process and
where forecasts fit in.
eg1.
To decide the rate, Reserve Bank needs to know the
expected future inflation, employment, and GDP when the
rate does not change and when the rate changes.
eg2.
To decide investments in human resource and infrastructure,
businesses need to know the expected future demand for
their products.
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Ch.3 Basics of Forecasting

Forecast object
This is usually a future event of interest.
Forecast outcome: quantitative/qualitative
eg. Winner of the next election (qualitative)
Next quarters GDP growth rate (quantitative)

Forecast timing
eg. When will the next election be held?
When will GDP growth rate become negative?

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Ch.3 Basics of Forecasting

Forecast horizon
This is the number of periods to the target date.
h-Step ahead forecast
eg. 4-quarter-ahead forecast of GDP growth rate:
0.6% (quarterly)
f.o.

q1
0.7

q2
0.9

q3
0.8

q4
0.6

h-Step ahead extrapolation (a sequence of forecasts)

eg. 4-quarter-ahead extrapolation of GDP growth rate:
0.7%, 0.9%, 0.8%, 0.6% (quarterly)
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Ch.3 Basics of Forecasting

Information set
This includes historical data relevant to forecast objects.
The quality of forecasts depends on
The quality and quantity of data
The skills and experience in exploiting data

Notation
Let y be the variable of interest. The info set at t is
t = { y1 , y2 ,..., yt ; x1 , x2 ..., xt },

Everything
useful & observed
at Date t

where x is a covariate useful to explain y.

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Ch.3 Basics of Forecasting

Loss function
It measures the badness of forecasts.
Notation

y:
y :

variable to be forecast;
forecast for y ;
e = y y : forecast error;
L( y, y ) : loss function, usually L = L( y y ) = L(e).

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Ch.3 Basics of Forecasting

Loss function
Required properties of L(e)
L(0) = 0;
(no loss with perfect prediction)
L(e) is increasing in |e|;
(further away from zero the error, larger the loss)
L(e) is continuous;
(small change in error leads to small change in loss)
L(e)

Asymmetry
under-forecast may
incur more costs.

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Ch.3 Basics of Forecasting

Loss function
Symmetric loss functions
e.g.
Quadratic: L(e) = e2

(most commonly used)

Absolute: L(e) = |e|

Asymmetric/discrete loss functions

e.g.

0, if y and y move in the same direction

L( y, y ) =
1, otherwise

Loss L is random (as y is random).

How do we measure the quality of forecasts?
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Ch.3 Basics of Forecasting

Loss function
Expected loss
We average L using the distribution of y:

Expectation:
average weighted
by probability

expected loss = E{L( y, y )}.

It measures the badness of forecasts on average.

e.g. Assume y = 0 or 1 with probability 0.5.
The loss function is quadratic.
For predictor y1 = 0, the expected loss is 0.5.
For predictor y 2 = 0.5,
L(e) = (y-.5)2
the expected loss is 0.25.

E{L(e)} =
(1-.5)2(.5) + (0-.5)2(.5)

Optimal forecast
Choose y to minimise expected L for a given info set.
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Ch.3 Basics of Forecasting

Loss function
Mean squared forecast error
(quadratic loss)
MSFE = E{( y y ) 2 }

We can only
choose y-hat.

= E{( y y ) 2 } + E{( y y ) 2 }

where y = E{ y}.

E should be evaluated
relative to given info set, ie,
conditional expectation.

Optimal forecast under MSFE

MSFE is minimised by choosing y * = y = E{ y}.
e.g. In previous example: y 2 is optimal under MSFE.
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Ch.3 Basics of Forecasting

Forecast statement
This is the presentation of forecasts,
which depends on the decision environment.
Point forecast (simplest)
It is a single-value prediction.
eg. 4th quarter GNP growth point forecast = 0.6%

Prob(future y is in

Interval forecast
the interval) = 0.9
It is an interval with a coverage probability.
eg. 4th quarter GDP growth 90%-interval-forecast = [0.4%, 0.8%]

Distribution forecast (most sophisticated)

It is a distribution about the future y.
eg. 4th quarter GDP growth distribution forecast is N[0.6%, (0.2%)2].
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Ch.3 Basics of Forecasting

Parsimony principle

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800
600
400

GDP ($billion)

eg.
Data
y = Australian annual GDP
Model-1:
y = a + bYear + error
Model-2:
y = a + bYear + cYear2 + error

1000

1200

A model is a simplified description of reality.

It should capture the major features of data.

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1970

1980

1990

2000

2010

Year

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Ch.3 Basics of Forecasting

Parsimony principle
Simple model
It emphasises important features and ignores many
unimportant details.
Easy to implement
Experience: simple models often do well in forecasting.

Complex model
It captures more details of data. But details may blur
important features.
More details could contain more noises.
Harder to implement, carries more estimation errors.
forecast error
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description error
estimation error
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Ch.3 Basics of Forecasting

Parsimony principle
Parsimony principle
Other things being equal, simpler models are preferred.

eg.

USD/AUD exchange rate:

(i)

yT +1 = yT ;

(ii)

yT +1 = yT + xT .

Unless Model (ii) has proven better, we will use Model (i)

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Ch.3 Basics of Forecasting

Conditioning on information set

Unemployment
1200

1000

800

'000

eg.
Predict
at Feb/82
Predict
at Feb/88
Predict
at Feb/94

600

400

200

0
Feb-98

Feb-96

Feb-94

Feb-92

Feb-90

Feb-88

Feb-86

Feb-84

Feb-82

Feb-80

Feb-78

Different info set lead to different forecasts.

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Ch.3 Basics of Forecasting

Summary

Forecasts are made to support decision making

Essence of forecasting
Know your purpose
Future uncertainty
Know your data
Concepts:
know your tools

forecast object
forecast horizon
information set
loss function
forecast statement

Parsimony principle
Forecasts are based on available information set
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